We all have heard multiple quotes and quips on the power of compounding by great investors. Hence, I will not give any gyaan on the compounding theme.
What I do want to illustrate is a quick and dirty table to evaluate investments. But that comes later. Trouble-sharing first 🙂
I have had some trouble in evaluating investments. The trouble is/was two-fold:
a) Quality companies vs Cigar butt companies: Assuming a fixed level of cash that you have, there are some cigar butts in the market which can give you a quick 20-40% return if things turn out well versus a few quality companies which can compound at 15% year on year. The deal though is you need to get out once the cigar butt is fairly valued versus continuing to stay invested in quality companies. Let’s say in an optimistic scenario we do get out of this cigar butt investment successfully, we have the problem of re-investment. The problem of re-investment is not simple since you may no longer have any undervalued stocks to invest in. You’ll probably earn 10% on a RD (or a ultra short term debt fund) and that’s about it. Compare this scenario with investing in a quality company (say a Page/GSK etc) where you don’t have to worry about getting out at the right moment/constantly monitor stuff/significant re-investment problem. These are steady compounders, which if some basic stuff goes well will compound atleast 15-20% for the next few years.
b) Falling markets: I have had this peculiar fascination with opportunity cost (which sometimes has stumped me into stupor). In a falling market, I want to invest in say Stock A which can give me say 20% returns for the next 5 years from that invested price. If the market falls some more, I might have another stock, say Stock B which can give me 30% returns for the next 3 years from that invested price. Assuming I already invested in Stock A, should I get out and invest in Stock B? Or should I stay invested in Stock A? If the stock market falls further, will I have a Stock C that can give me higher returns and ad infinitum. I need to invest based on which company can generate higher returns for a longer period of time. (In general, to avoid the stupor I have learnt to just invest if I can get a 20% CAGR for 5 years).
Net-net, the question I am trying to answer based on the two-fold trouble is – how many times will my money multiply by, in say x years?
I have come up with a matrix for a quick and dirty check of how many times will my money multiply by, given a CAGR and number of years (instead of calculating every single time). Here it is –
Taking the example above, a 20% CAGR for 5 years (refer grey shaded areas) – my money multiplies by 2.5 times. 30% CAGR for 3 years – my money multiplies by only 2.2 times. Hence, the prudent way is to invest in 20% for 5 years.
Also the reason why investing in quality companies for a longer timeframe helps better even though the CAGR for a year or two might be less than investing in a cigar butt for a similar time frame.
As I said earlier, no genius in the matrix. We can calculate it using the compound interest formula every single time. I am lazy though, and hence this matrix helps me for a quick check 🙂
P.S: If you find a stock with 60% CAGR for 10 years, please drop me a mail. We both can retire comfortably 🙂